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Public debt: some basics

02 November, 2002 12:00am

Why fiscal surpluses?

Fred Argy

The claim is often made that governments which run structural budget surpluses, and achieve this goal through expenditure restraint, are better economic managers than those which run structural deficits. In fact structural surpluses can often indicate weak, lazy government rather than economic competence and virility.

As conventionally measured, a "structural underlying budget surplus" means that over the long term (and after adjusting for asset sales) current revenue exceeds all cash outlays - recurrent and capital - i.e. all capital expenditures are financed out of current revenue and net public debt is steadily run down.

Why is it viewed as reprehensible for a government to finance new investment out of borrowings? Successful public companies do it all the time. Indeed, if a company is reasonably low-geared (i.e. with a low debt to equity ratio) and has sound investment opportunities available to it, it would be reprehensible of that company not to borrow.

Government borrowing should have similar tests applied to it. Governments must show the proposed investment is sound; that it can best be financed by the public sector; and that their balance sheets are strong enough to bear an increase in debt.

To meet the first test, there needs to be a proper cost-benefit evaluation, i.e. with the cost of government capital measured in terms of its opportunity cost not just the bond rate, and with wider community and economic spin-offs taken fully into account. If it is found that the proposed investment is sound and that the equity risks are such that they can be best managed by governments, then the first two hurdles have been successfully overcome.

Next is the balance sheet hurdle. It would be hard to argue that Australian governments are over-loaded with debt or over-geared. In fact they have a very low level of indebtedness relative to GDP compared with their counterparts overseas. We cannot assess gearing ratios because we don't have proper balance sheets (apart from "trial" official estimates which have been severely criticised). Much is made of the unfunded superannuation liabilities of governments but if accrual accounts were applied consistently and public assets were measured exactly the same way as the superannuation liabilities, the net financial position of governments would be largely unaffected. In any case, governments have ultimate resort to the taxation power. More importantly, the role of governments is to improve the national balance sheet even if it occasionally weakens their own net asset position.

But shouldn't we draw the line somewhere on public sector borrowings? Yes, governments need to be fiscally responsible in two senses. First, in general governments should not borrow more than they "invest", i.e. they should aim to maintain or improve their net worth. Secondly, the interest rate on public debt should never exceed the growth rate of GDP so that the debt servicing burden does not increase. All this implies a zero cash deficit only on recurrent budget not an overall cash surplus.

The key point is that there should be no prior presumption against public investment. Yet this is precisely what a rigid stance on structural fiscal surpluses implies (given the reluctance of governments to raise taxes).

This presumption against public investment has unfortunate consequences. It creates a bias against those infrastructure investments which have substantial "externalities" (hospitals, educational institutions, public transport and community services) relative to those which produce commercial returns. It leads to many infrastructure investments (e.g. urban roads) being financed by private sector equity and costing the community much more than if they had been financed by the public sector. And it tends to hurt those who are relatively poor because it makes governments economize on community services such as education, health, public housing, public transport, and labour market programs.

Public sector surpluses and the balance of payments

Another argument is that governments should run surpluses to build up Australia's pool of net national savings and reduce its dependence on foreign debt.

This argument has a core of truth but it needs to kept in perspective. Our external debt levels are high but not alarmingly so. External debt levels stabilized in the late 1980s, both relative to GDP and relative to our net wealth, and our debt servicing costs (interest payable abroad as a ratio of export income) have been falling for nearly a decade. Nor are current foreign debt levels inordinately high internationally (New Zealand and Canada have considerably higher debt/GDP ratios).

In any case, whatever a country's foreign debt, it makes sense for that country to borrow so long as the increased debt is matched by productive assets which enhance its national income more than its debt obligations. Such borrowing helps to ease the nation's debt burden in the long term.

Nor is there any certainty that a fall in net public sector borrowing will improve the external accounts. The recent experience of Australia, New Zealand and US shows that when governments borrow less the private sector often borrows more.

True, international financial markets closely watch our external accounts. But these markets are generally sophisticated and can distinguish between benign and malign deficits, as indeed they have shown themselves able to do for years with countries like NZ. At worst Australian industry might have to pay an extra 1/4 per cent or so to borrow overseas than otherwise.

All in all, fiscal policy should not be too preoccupied with the current account deficits. Sure, governments should be seen to be fiscally responsible (in the sense defined earlier) and should respond to external deficits where these are a symptom of an underlying economic malaise. However, to strive for a steady decline in foreign liabilities is unnecessary and counter-productive for long-term economic growth.

Structural fiscal surpluses and inter-generational equity

Another claim is that structural fiscal surpluses are needed to protect the interests of future generations. Again, this is being too alarmist. To begin with, if governments are concerned about future generations their goal should be to maintain or improve net worth (theirs or the nation's) - not to reduce outstanding debt. If governments borrow today and invest wisely for the long term they bequeath debt to their successors but they also bequeath additional assets e.g. long-lived infrastructure, improved knowledge, a better public health care system, superior economic, cultural, political and legal institutions, a more stable and cohesive society etc.

In any case, well handled, the projected increase in age dependency should not impose an undue burden on future generations. The age hump in the population only starts to seriously show up in Australia about 15 years from now and then extends for 30 to 40 years after that. Between now and 2015, private saving seems set to increase substantially because it is the peak saving period for baby boomers and because of the effects of compulsory superannuation. In any case, projections of dependency ratios are usually based on very conservative estimates of labour participation rates. With the prospect of fewer school leavers, a tighter labour market after 2010, and an improved health and life expectancy, a significant increase in participation rates is likely.

Nor should one assume that policies will remain static. There could for example be changes in the official retirement age for pensioners, further incentives to pensioners to postpone retirement, increases in the preservation age, restrictions on lump-sum payments, increased provision for compulsory employee contributions or changes in means test provisions.

To sum up, governments must try to balance their budgets on current account over the long term, but striving for structural cash surpluses, with lower and lower public debt levels, is hard to justify economically and it threatens to erode our fair go society.

Fred Argy, AM, OBE, is a Visiting Fellow at the Australian National University, an Adjunct Professor at Queensland University, and the author of Australia at the crossroads: radical free market or a progressive liberalism? (Allen & Unwin: Sydney, 1998) and a forthcoming book on The changing face of Australian egalitarianism (Allen & Unwin). This article was originally produced as part of a 1998 radio and online project presented by Monash University, Radio Australia, Radio National and ABC Online on Money, Markets & the Economy in 1998 and is reproduced with the author's kind permission. The Howard government's discussion paper about Review of the Commonwealth government securities market, which foreshadows a move to zero public debt, was released by the Treasurer, Peter Costello, on 30 October 2002.